C h a p t e r

8 POSSIBILITIES,
PREFERENCES,
AND CHOICES

Key Concepts FIGURE 8.1

The Budget Line
„ Consumption Possibilities

Soda (six packs per month)

The budget line shows the limits to a household’s con- 5
sumption. Figure 8.1 graphs a budget line; the formula
for the budget line in this figure is: 4
y P 
Q soda = −  movies  Q movies
Psoda  P soda  3

♦ A household’s real income is the income expressed

2
as a quantity of goods the household can afford to
buy. In terms of soda, ( y Psoda ) is the household’s
1
real income. An increase in income (y) shifts the
budget line rightward but does not change its slope.
♦ The magnitude of the slope of the budget line 1 2 3 4 5 6
( Pmovies Psoda ) is the relative price of a movie in Movies (per month)

terms of a soda.
♦ Changes in the relative price rotate the budget line.
FIGURE 8.2
A fall in the price of movies, the product on the
horizontal axis, rotates the budget line outward so Indifference Curves
that it becomes flatter.
Soda (six packs per month)

„ Preferences and Indifference Curves

5
An indifference curve is a curve showing combinations
of goods among which a person is indifferent. Figure
4
8.2 illustrates a family of indifference curves.
♦ Indifference curves farther from the origin are pre-
3
ferred over those closer to the origin.
The marginal rate of substitution (MRS MRS)
MRS is the rate at I3
2
which the household is willing to give up the good on
the vertical axis (soda) for an additional unit of the I2
1
good on the horizontal axis (movies) and still remain
indifferent. The magnitude of the slope of the indiffer- I1
ence curve equals the MRS.
0 1 2 3 4 5 6
♦ The diminishing marginal rate of substitution is Movies (per month)
the tendency for a person to be willing to give up

133
134 CHAPTER 8

less of the good on the vertical axis to get one more FIGURE 8.3
unit of the good on the horizontal axis, while re- The Best Affordable Point
maining indifferent (that is, on the same indiffer-
ence curve) as the quantity of the good on the

Soda (six-packs per month)

horizontal axis increases.
♦ Goods that are substitutes have straighter indiffer- Budget
line
ence curves; goods that are complements have more
bowed indifference curves.

„ Predicting Consumer Behavior S

The household chooses the best affordable point. This

point is the combination of goods on the budget line
and on the highest possible indifference curve. Figure
8.3 illustrates the best affordable point, where the I
household consumes M movies and S six-packs of soda
per month. At this optimal point: M Movies (per month)

♦ the budget line and indifference curve are tangent so

that the marginal rate of substitution equals the
FIGURE 8.4
relative price.
A Fall in the Price of a Movie
The price effect is the change in the quantity con-
sumed of a good resulting from a change in its price.
Soda (six-packs per month)

When the price of a movie falls, the budget line rotates

as shown in Figure 8.4 and the consumption of movies New
increases from M1 to M 2 . budget
The fall in the price of a movie increases the quantity of line
movies demanded, which shows how this analysis can
be used to derive the demand curve for movies.
The price effect can be divided into the substitution
effect plus the income effect.
♦ The income effect is the change in consumption
I2
resulting from a change in income. For normal
goods, higher income increases consumption and I1
the demand curve shifts rightward; for inferior
M1 M2
goods, higher income decreases consumption and Movies (per month)
the demand curve shifts leftward.
♦ The substitution effect is the change in consump-
„ Work-Leisure Choices
tion resulting from a change in price accompanied
by a (hypothetical) change in income that leaves the Labor supply decisions can be analyzed using an indif-
household indifferent (on the same indifference ference curve/budget line approach.
curve) between the initial and new situations. For ♦ A budget line and the indifference curves exist be-
all goods, the substitution effect of a price fall in- tween leisure and consumption of other goods.
creases consumption of the good.
♦ A rise in the wage rate changes the slope of the
♦ For normal goods, the substitution and income ef- budget line, creating income and substitution ef-
fects from a price change work in the same direc- fects. The substitution effect leads to more hours
tion, so a lower price unambiguously increases spent working, but the income effect leads to fewer
consumption. For inferior goods, the substitution hours spent working.
and income effects work in opposite directions.
POSSIBILITIES, PREFERENCES, AND CHOICES
Helpful Hints
1. A PERSPECTIVE ON THE CHAPTER : The analysis
in this chapter clarifies economists’ general view
that people strive to make themselves as well off as
possible. However, people face constraints. These
constraints, which limit the range of possible
choices, depend on income and the prices of goods
and are represented graphically by the budget line.
Doing the best means finding the most preferred
outcome consistent with those constraints.
Graphically, the problem is to find the highest in-
difference curve attainable given the budget line.
To make graphical analysis feasible, we restrict our-
selves to choices between only two goods, but the
same principles apply in the real world to a broader
array of choices.
2. INCOME, PRICES, AND INDIFFERENCE CURVES :
Indifference curves plot people’s preferences and do
not depend on their incomes or the prices of the
goods. For example, an indifference curve indicates
how much a person likes (or dislikes) lobster with-
out regard to the price of a lobster or the person’s
income. When the price of a lobster or the individ-
ual’s income changes, the budget line changes, but
the indifference curves do not change. If lobster is a
normal good, higher income leads to more lobster
being consumed. But the reason that more lobster
is consumed is that the budget line has shifted out-
ward, making more combinations of goods afford-
able.
Questions
„ True/False and Explain
Consumption Possibilities
11. The budget line has a negative slope and is linear.
12. The magnitude of the slope of the budget line is a
relative price.
13. An increase in income shifts the budget line out-
ward and makes it steeper.
Preferences and Indifference Curves
14. A person is indifferent between any combination of
goods on a particular indifference curve.
135
15. Indifference curves farther from the origin are pre-
ferred to those closer to the origin.
16. The magnitude of the slope of a person’s indiffer-
ence curve is the marginal rate of substitution.
17. The marginal rate of substitution falls when mov-
ing upward along an indifference curve.
18. Goods that are perfect substitutes have L-shaped
indifference curves.
Predicting Consumer Behavior
19. The best affordable point of consumption is on the
budget line and on the highest attainable indiffer-
ence curve.
10. The law of demand can be derived from an indif-
ference curve diagram by using the diagram to de-
termine the impact changes in price have on the
person’s consumption bundle.
11. The substitution effect can be divided into the price
effect and the income effect.
12. For an inferior good, an increase in income shifts
the budget line leftward.
13. When the relative price of a good falls, the income
effect always leads to increased consumption of the
good.
Work-Leisure Choices
14. The indifference curve/budget line approach shows
that a rise in the wage rate definitely increases the
quantity of labor supplied.
15. Both the substitution effect and income effect from
a higher wage rate lead to an increase in the quan-
tity of labor supplied.
„ Multiple Choice
Consumption Possibilities
11. Which of the following statements best describes a
consumer’s budget line?
a. It shows all combinations of goods among which
the consumer is indifferent.
b. It shows the limits to a consumer’s set of afford-
able consumption choices.
c. It shows the desired level of consumption for the
consumer.
d. It shows the consumption choices made by a
consumer.
136
12. The magnitude of the slope of the budget line
a. is defined as marginal rate of substitution.
b. equals the relative price of the good measured
along the horizontal axis.
c. increases when income increases.
d. decreases when income increases.
13. The budget line can shift or rotate
a. only when income changes.
b. only when prices change.
c. when either income or prices change.
d. None of the above because changes in income
and prices do not shift or rotate the budget line.
Use Figure 8.5 for the next two questions.
FIGURE 8.5
Multiple Choice Questions 4 and 5
Soda (six-packs per month)
Budget line
Movies (per month)
14. Suppose that this consumer’s income increases and
nothing else changes. As a result, the consumer’s
budget line
a. rotates around the vertical intercept and becomes
steeper.
b. rotates around the vertical axis and becomes
shallower.
c. shifts rightward and becomes steeper.
d. shifts rightward and its slope does not change.
CHAPTER 8
15. Suppose that the price of a movie rises and nothing
else changes. This change means the budget line
a. rotates around the vertical intercept and becomes
steeper.
b. rotates around the vertical axis and becomes
flatter.
c. shifts rightward and becomes steeper.
d. shifts rightward and does not change its slope.
16. Sue consumes apples and bananas. Suppose that
Sue’s income doubles and that the prices of apples
and bananas also double. Sue’s budget line will
a. shift leftward but not change slope.
b. remain unchanged.
c. shift rightward but not change slope.
d. shift rightward and become steeper.
Preferences and Indifference Curves
17. As a consumer moves rightward along an indiffer-
ence curve, the
a. consumer remains indifferent among the differ-
ent combinations of goods.
b. consumer generally prefers the combinations of
goods farther rightward along the indifference
curve.
c. income required to buy the combinations of the
goods always increases.
d. relative price of both goods falls.
18. Indifference curves shift or rotate
a. only when income changes.
b. only when prices change.
c. when either income or prices change.
d. with none of the above because changes in in-
come and prices do not shift indifference curves.
19. If your local newspaper reported that wearing plaid
clothing was a sure way to obtain good grades, stu-
dents’
a. budget lines would shift rightward to compensate
for the higher price of plaid clothing.
b. budget lines would rotate so that more plaid
clothing would be purchased.
c. preferences would change in favor of more plaid
clothing.
d. None of the above.
POSSIBILITIES, PREFERENCES, AND CHOICES 137

10. Diminishing marginal rate of substitution means 13. Which of the following statements about Figure 8.6
that is correct?
a. the budget line has a negative slope. a. Point a is preferred to point d, but a is not
b. the budget line does not shift when people’s affordable.
preferences change. b. The consumer is indifferent between points d
c. indifference curves might have a positive slope. and c, but c is more affordable.
d. indifference curves will be concave. c. Point b is preferred to point d , but b is not
affordable.
11. If two goods are perfect substitutes, their d. Both points a and d cost the same, but a is pre-
a. indifference curves are positively sloped straight ferred to d.
lines.
b. indifference curves are negatively sloped straight 14. What is the best affordable point of consumption?
lines. a. a
c. indifference curves are L-shaped. b. b
d. marginal rate of substitution is infinity. c. c
d. d
12. If the indifference curves between two goods are L-
shaped, the goods are 15. A consumer is in equilibrium when the consump-
a. complementary goods. tion point is on
b. substitute goods. a. the budget line.
c. normal goods. b. an indifference curve.
d. inferior goods. c. the highest indifference curve that just touches
the budget line.
Predicting Consumer Behavior d. None of the above.
Use Figure 8.6 for the next two questions.
FIGURE 8.6
16. Which of the following is true when the consumer is
at the best affordable point?
Multiple Choice Questions 13 and 14
a. The point is on the budget line and highest at-
tainable indifference curve.
Hot dogs (quantity per month)

b. The slope of the budget line equals the slope of

the indifference curve.
c. The MRS equals the relative price.
d. All of the above are true at the best affordable
point.

d 17. Which of the following statements is true?

a a. The law of diminishing marginal rate of substi-
I3 tution means that indifference curves are convex
b
(bowed out).
c I2
b. A demand curve can be derived from the indif-
I1 ference curve/budget line analysis.
Hamburgers (quantity per month) c. Demand curves and indifference curves measure
the same things.
d. Demand curves and indifference curves have
negative slopes for the same reason.
138 CHAPTER 8

18. When the price of an orange falls, the income effect 22. The new consumer equilibrium is at point
a. increases the consumption of oranges if oranges a. a.
are a normal good. b. b.
b. increases the consumption of oranges if oranges c. c.
are an inferior good. d. d.
c. always increases the consumption of oranges.
d. always decreases the consumption of oranges. 23. When you examine the effect from a change in price
while (hypothetically) changing income to keep the
19. When oranges fall in price, the substitution effect consumer on the same indifference curve, you are
a. increases the consumption of oranges if oranges examining the
are a normal good. a. price effect.
b. increases the consumption of oranges if oranges b. income effect.
are an inferior good. c. substitution effect.
c. always increases the consumption of oranges. d. ceterus paribus effect.
d. always decreases the consumption of oranges.
24. When the price of a normal good falls, the income
Use Figure 8.7 for the next three questions. effect ____ the quantity demanded and the substi-
FIGURE 8.7 tution effect ____ the quantity demanded.
Multiple Choice Questions 20, 21, 22 a. increases; increases
b. increases; decreases
Tacos (quantity per month)

c. decreases; increases
d. decreases; decreases
a

25. An inferior good

a. has a substitution effect opposite that of a normal
good.
b b. has an income effect opposite that of a normal
good.
c. has a price effect opposite that of a normal good.
d I2 d. is one that breaks after its first use.
c
I1 Work-Leisure Choices
26. The substitution effect from a rise in the wage rate
Slices of pizza (quantity per month) a. motivates a decrease in leisure.
b. motivates an increase in leisure.
20. The change in the budget line is the result of a(n) c. has the same effect on leisure as does the income
a. fall in the price of a slice of pizza. effect.
b. fall in the price of a taco. d. None of the above.
c. increase in income.
d. None of the above 27. Over the past 100 years, the quantity of labor sup-
plied has decreased as wages have risen. This change
21. With the change in the budget line, the consumer’s indicates that the income effect
real income measured in units of tacos a. and the substitution effect have both discouraged
a. definitely increased. leisure.
b. definitely decreased. b. and the substitution effect have both encouraged
c. did not change. leisure.
d. might have changed, but it is impossible to tell c. encouraging leisure has dominated the substitu-
from the figure. tion effect discouraging leisure.
d. has not affected the work–leisure choice.
POSSIBILITIES, PREFERENCES, AND CHOICES 139

„ Short Answer Problems FIGURE 8.9

1. Why do indifference curves have negative slopes? Short Answer Problem 4

2. Jan and Dan eat bread and peanut butter and have 6

Lizards (number per year)

the same income. Because they face the same prices,
they have identical budget lines. Currently, Jan and 5
Dan consume the same quantities of bread and
peanut butter; they have the same best affordable 4
consumption point. Jan views bread and peanut
butter as close (though not perfect) substitutes, 3
whereas Dan considers bread and peanut butter to
be quite (but not perfectly) complementary. On the
2
same diagram, draw a budget line and representa-
tive indifference curves for Jan and Dan. (Measure
1
the quantity of bread on the horizontal axis.)

FIGURE 8.8 0 1 2 3 4 5 6
Short Answer Problem 3 Snakes (number per year)

6
Lizards (number per year)

4. Figure 8.9 again shows Igor’s indifference curves.

5 a. Snakes cost $20, lizards cost $20, and Igor’s
income is $60. Draw Igor’s budget line in Fig-
4 ure 8.9. How many snakes does Igor buy? How
many lizards?
3 b. For his superior work in finding brains, Igor’s
master gives him a raise to $120. In Figure 8.9
2
draw Igor’s new budget line. After the raise, how
many snakes does Igor buy? How many lizards?
For Igor, are snakes and/or lizards a normal
1
good?
5. Ms. Muffet consumes curds and whey. The initial
0 1 2 3 4 5 6 price of curds is $1 per unit, and the price of whey
Snakes (number per year) is $1.50 per unit. Ms. Muffet’s income is $12.
a. What is the relative price of curds?
3. Three of Igor’s indifference curves are illustrated b. Derive Ms. Muffet’s budget equation and draw
Figure 8.8. her budget line on a graph. ( Measure curds on
a. Suppose that the price of a snake is $10, the the horizontal axis.)
price of a lizard is $20, and Igor has $60 to c. On your graph, draw an indifference curve so
spend on snakes and lizards. Carefully draw his that the best affordable point corresponds to 6
budget line in Figure 8.8. How many snakes units of curds and 4 units of whey.
does Igor buy? How many lizards? d. What is the marginal rate of substitution of
b. Suppose that the price of a snake spirals to $20 curds for whey at this point?
while the price of a lizard does not change. If e. Show that any other point on the budget line is
Igor’s income stays at $60, draw his new budget inferior.
line in Figure 8.8. Now how many snakes does
6. For the initial situation described in problem 5,
Igor buy? How many lizards? Are snakes and liz-
suppose that Ms. Muffet’s income now increases.
ards substitutes or complements?
a. Illustrate graphically how the consumption of
c. When is Igor better off: before or after snakes go
curds and whey are affected if both goods are
up in price? How can you tell?
140 CHAPTER 8

normal. (Precise numerical answers are not nec- FIGURE 8.11

essary here. In your graph, just show whether Short Answer Problem 8 (c)
consumption increases or decreases but do not
3

Price of wine (dollars per bottle)

worry about specific numbers.)
b. Draw a new graph showing the effect of an in-
crease in Ms. Muffet’s income if whey is an infe-
rior good.
2
7. Return to the initial circumstances in problem 5.
Now, suppose that the price of curds doubles to $2
a unit while the price of whey remains at $1.50 per
unit and income remains at $12.
1
a. Draw the budget line before and after the price
change.
b. Why is the initial best affordable point (label it
point a) no longer the best affordable point?
c. Use your graph and show the new best afford- 0 1 2 3 4 5 6
able point and label it d. What has happened to Wine (bottles per month)
the consumption of curds?
d. Use your graph to illustrate the substitution and b. The price of a bottle of wine falls to $1. The
income effects from the price change. Label the price of a loaf of bread remains at $1, and
point created by the substitution effect b. Carolyn’s income is constant at $6. Draw her
new budget line in Figure 8.10. How many
FIGURE 8.10 bottles of wine does Carolyn now buy?
Short Answer Problem 8 (a) and 8 (b) c. Assume that Carolyn’s demand curve is linear.
In Figure 8.11 draw Carolyn’s demand curve for
Wine (bottles per month)

6
wine.
5
FIGURE 8.12
Short Answer Problem 9
4
Income (dollars per week)

I3
3

I2
2

I1 Income-time
1
budget line

0 1 2 3 4 5 6 I3
Bread (loaves per month)
I2

8. Figure 8.10 illustrates Carolyn’s indifference map
between bread and wine.
a. The price of a bottle of wine is $2, and the price
of a loaf of bread is $1. Carolyn has $6 to spend
on bread and wine. In Figure 8.10 draw her
budget line. How many bottles of wine does
Carolyn buy?
I1
168
Leisure (hours per week)
9. In Figure 8.12 indicate the initial hours of leisure
this person enjoys. Suppose that the wage rate rises
so that the person moves to another of the indiffer-
POSSIBILITIES, PREFERENCES, AND CHOICES
ence curves already in the figure; that is, the budget
line rotates so that another indifference curve is
now optimal. Draw the new budget line and show
the new equilibrium amount of leisure. How did
the amount of leisure change with the higher wage
rate? How did the amount of labor supplied change
as the wage rate rose? What accounts for your an-
swers to the last two questions?
141
„ You’re the Teacher
1. “I see that we can use this indifference curve/budget
line approach to derive demand curves. But why
bother? I mean, after all, why not just use the de-
mand curves like we’ve been doing all along and
not worry about this other stuff?” This question is
reasonable. Tell your friend why this other stuff is
worth bothering about.
2. “I finally understand this chapter: Indifference
curves and demand curves are the same thing! My
studying is beginning to pay off.” Actually your
friend is not studying enough. Help your friend by
explaining why indifference curves and demand
curves are not the same.
142
Answers
„ True/False Answers
Consumption Possibilities
11. T The budget line is straight; indifference curves
are concave (bowed toward the origin).
12. T The magnitude of the slope of the budget line is
the relative price of the good on the horizontal
axis in terms of the good on the vertical axis.
13. F An increase in income shifts the budget line
outward, but does not change its slope.
Preferences and Indifference Curves
14. T This definition is why a consumer is indifferent
between points on a particular indifference
curve.
15. T Indifference curves farther from the origin have
more potential consumption of all goods and
services and so are preferred.
16. T The statement tells how to measure the marginal
rate of substitution.
17. F The principle of diminishing marginal rate of
substitution means that the marginal rate of sub-
stitution falls while moving downward along an
indifference curve.
18. F Goods that are complements have L-shaped in-
difference curves.
Predicting Consumer Behavior
19. T The best affordable point is best because it is on
the highest indifference curve and is affordable
because it is on the budget line.
10. T The question tells how a demand curve can be
derived.
11. F The price effect can be divided into the substi-
tution effect and the income effect.
12. F The budget line shifts rightward, but the equi-
librium amount of the good consumed decreases.
13. F The income effect leads to increased consump-
tion for normal goods and decreased consump-
tion for inferior goods.
Work-Leisure Choices
14. F A rise in the wage rate might either increase or
decrease labor supply. See the next answer for
more details on why this ambiguity occurs.
CHAPTER 8
15. F The income effect decreases the quantity of labor
supplied, but the substitution effect increases the
quantity. The net effect on the supply of labor
from the increase in the wage rate is ambiguous.
„ Multiple Choice Answers
Consumption Possibilities
11. b The budget line illustrates the different combi-
nations of goods an individual can afford. In this
sense it is like a menu, showing what can be pur-
chased. But in order to determine what will be
purchased, information is needed on the con-
sumer’s preferences about the different combi-
nations of goods.
12. b The slope indicates how many units of the good
measured on the vertical axis must be given up
in order to gain another unit of the good meas-
ured on the horizontal axis.
13. c Income and price changes shift or rotate the
budget line, not indifference curves.
14. d Changes in the relative price rotate the budget
line; changes in income shift it in a parallel
fashion.
15. a A rise in the price of a movie does not change
the vertical intercept ( y Psoda ), but the mag-
nitude of the slope ( Pmovies Psoda ) increases.
16. b The relative price of bananas and apples does
not change because both prices doubled, so the
slope of the budget line is unchanged. In addi-
tion, the intercepts do not change because the
higher income matches the higher prices. So, the
budget line does not change.
Preferences and Indifference Curves
17. a By definition, the consumer is indifferent be-
tween any consumption combination on an in-
difference curve.
18. d Only changes in the individual’s preferences
shift the indifference curves.
19. c Preferences change because now students “like”
plaid clothing more than before.
10. d The diminishing marginal rate of substitution
means that an indifference curve becomes flatter
while moving rightward along it so that more of
the good measured on the horizontal axis is con-
sumed.
POSSIBILITIES, PREFERENCES, AND CHOICES 143

11. b The more closely two goods substitute for each
other, the more closely their indifference curves
approach being straight lines.
12. a Perfect complements have L-shaped indifference
curves.
27. c The income effect from a higher wage rate en-
courages people to spend less time at work and
more at leisure; the substitution effect is the op-
posite, encouraging more time at work and less
at leisure.

Predicting Consumer Behavior

13. a Point a is preferred because it is on a higher in-
difference curve, but it is not affordable because
it lies beyond the budget line.
14. d Point d is the point on the highest indifference
curve that is affordable.
15. c The consumption bundle represented by the
point on the budget line where the highest in-
difference curve touches the budget line is the
best affordable consumption bundle.
16. d All the statements accurately characterize con-
sumer equilibrium.
17. b In other words, demand curves are the result of
people selecting the best affordable consumption
combination.
18. a The income effect of a lower price motivates an
„ Answers to Short Answer Problems
1. An indifference curve shows how much the con-
sumption of one good must increase as the con-
sumption of another good decreases in order to
leave the consumer indifferent (no better or worse
off).
It has a negative slope because both goods are desir-
able. In order to not be made worse off, as the con-
sumption of one good decreases, consumption of
the other good must increase. This relationship im-
plies a negative slope.
FIGURE 8.13
Short Answer Problem 2

Peanut butter (jars per year)

increase in the consumption of normal goods
only. The income effect motivates a decrease in
the consumption of inferior goods.
19. c The substitution effect from a lower price always
motivates an increase in the consumption of the
relatively cheaper good. P
20. b When the price of a taco falls, the maximum
amount of tacos that can be purchased increases, IDan
but the maximum amount of pizza slices that
can be purchased does not change.
21. a Real income increased because more tacos can be IJan
purchased.
B Bread (loaves per year)
22. b After the price change, point b is on the highest
affordable indifference curve.
23. c This question defines the substitution effect.
2. Figure 8.13 shows Jan and Dan’s budget line and
24. a For normal goods, both the substitution and
their indifference curves. Because Jan views bread
income effects from a lower price will increase
and peanut butter as substitutes and Dan views
the quantity demanded.
them as complements, Jan’s indifference curve is
25. b Increases in income increase the demand for a more linear than Dan’s and Dan’s is more L-shaped
normal good and decrease the demand for an than Jan’s.
inferior good.
In general, the more the goods are viewed as sub-
Work-Leisure Choices stitutes, the more linear are the indifference curves.
The more the goods are viewed as complements, the
26. a The substitution effect of a higher wage rate
more L-shaped are the indifference curves.
increases the quantity of labor supplied.
144 CHAPTER 8

FIGURE 8.14 c. Igor was better off before the price of a snake
Short Answer Problem 3 (a) rose. A comparison of Figures 8.14 and 8.15 re-
veals that Igor was on a higher indifference curve
6 before the price of a snake rose, so he preferred
Lizards (number per year)

the situation before snakes rose in price.

5
FIGURE 8.16
4 Budget Short Answer Problem 4 (a)
line
6

Lizards (number per year)

3

5
2

4 Budget
1 line
3
0 1 2 3 4 5 6
Snakes (number per year) 2

3. a. Figure 8.14 shows the budget line. The point 1

with the highest attainable utility is indicated by
the circle, where the budget line touches the
0 1 2 3 4 5 6
highest possible indifference curve. At this point
Snakes (number per year)
Igor buys 4 snakes and 1 lizard.

FIGURE 8.15 4. a. Figure 8.16 show that Igor buys 1 snake and 2
Short Answer Problem 3 (b) lizards.

6 FIGURE 8.17
Lizards (number per year)

Short Answer Problem 4 (b)

5
6
Lizards (number per year)

4 Budget
line 5

3
4 Budget
line
2
3

1
2

0 1 2 3 4 5 6 1
Snakes (number per year)

b. Figure 8.15 illustrates Igor’s new budget line. 0 1 2 3 4 5 6

After the price hike for snakes, Igor buys 1 snake
and 2 lizards. Lizards and snakes are substitutes.
The increase in the price of a snake increases the
quantity of lizards that Igor buys.
Snakes (number per year)
b. The increase in income shifts Igor’s budget line,
as indicated in Figure 8.17. After his increase in
income, Igor buys 3 snakes and 3 lizards. For
POSSIBILITIES, PREFERENCES, AND CHOICES 145

Igor, both snakes and lizards are normal goods the slope of the budget line and thereby calculate
because he buys more of both when his income the marginal rate of substitution. At the best af-
increases. fordable point a, the indifference curve and the
5. a The relative price of curds is the money price of budget line have the same slope. (The fact that
curds divided by the money price of whey: the slope of the indifference curve equals that of
($1 per unit of curds) ($1.50 per unit of whey) the budget line at the best affordable point is the
or 2 3 whey per curd. hallmark of the best affordable point.) So we can
b. Let Pc = the price of curds, Pw = the price of obtain the marginal rate of substitution of curds
whey, Q c = quantity of curds, Q w = quantity of for whey by using the slope of the budget line.
whey, and y = income. The budget equation, in Because the slope of the budget line is − 2 3, the
general form, is: marginal rate of substitution is 2 3. For exam-
ple, Ms. Muffet is willing to give up 2 units of
y P 
Qw = − c Q c whey in order to receive 3 additional units of
Pw  Pw  curds.
Because Pc = $1, Pw = $1.50, and y = $12, Ms. e. Because indifference curve I 2 lies above the
Muffet’s budget equation is specifically given by: budget line (except at point a), every other point
on the budget line is on a lower indifference
Q w=8 − 2Qc
3 curve. For example, take point b. Point b lies on
The graph of this budget equation, the budget indifference curve I 1 , which is less preferred
line, is given in Figure 8.18. than indifference curve I 2 . Just like point b,
every other point on the budget line lies on a less
FIGURE 8.18 preferred indifference curve and so every other
Short Answer Problem 5 point is inferior to point a. As a result, point a is
the equilibrium point.
15
Quantity of whey

FIGURE 8.19
Short Answer Problem 6 (a)
12
15
Quantity of whey

9 Budget
line
8 12

6 10 New budget
a 9 line
4 8
3
I2 6 c
b
I1 a
0 3 6 9 4
12 15 I3
3
Quantity of curds
I2

c. Indifference curve I 2 is the indifference curve

0 3 6 9 12 15
tangent to the budget line so that Ms. Muffet’s Quantity of curds
best affordable point — that is, her equilibrium
point — is point a, with consumption of 6 units 6. a. An increase in income causes a parallel rightward
of curds and 4 units of whey. shift of the budget line, as shown in Figure 8.19.
d. The marginal rate of substitution is the magni- If both curds and whey are normal goods, Ms.
tude of the slope of the indifference curve at Muffet moves to a point such as c, at which the
point a. We do not know the slope of the indif- consumption of both goods has increased.
ference curve directly, but we can easily compute
146 CHAPTER 8

FIGURE 8.20 point as in Figure 8.18.) Here the new budget

Short Answer Problem 6 (b) line following a rise in the price of curds to $2 is
illustrated.
15
Quantity of whey

b. After the price rise, point a is no longer the best

affordable point because now it is no longer af-
12 fordable.
New budget c. The new best affordable point (labeled d in Fig-
10 line
ure 8.21) indicates a decrease in the consump-
9
8
tion of curds. That is as expected because the
price of curds rose.
6
FIGURE 8.22
a
4 d Short Answer Problem 7 (d)
3 I3
I2 15

Quantity of whey
0 3 6 9 12 15
12 Hypothetical
Quantity of curds
budget line

b. If whey is an inferior good, its consumption 9

decreases as income increases, as illustrated in 8
Figure 8.20. Again, the budget line shifts right- b New budget
6 line
ward, as in part (a), but Ms. Muffet’s preferences
are such that her new consumption point is a
4
given by a point such as d, on indifference curve 3 d
I 3 , where the consumption of whey has de- I2

clined. I1
0 3 6 9 12 15
FIGURE 8.21 Quantity of curds

Short Answer Problem 7 (a)

d. The substitution effect is the movement from
15
Quantity of whey

point a to point b, and the income effect is the

movement from point b to point d. The key to
12 the substitution effect is that point b is on the
same indifference curve as point a. The hypo-
New budget thetical budget line that determines point b has
9
line the same slope as the actual new budget line,
8
however Ms. Muffet’s income has been (hypo-
6 thetically) increased along the hypothetical
a
budget line to keep her on the same indifference
4 curve.
3 d
I2
The substitution effect always leads to a decrease
in the consumption of the good whose relative
I1 price has risen and an increase in the consump-
0 3 6 9 12 15
tion of a good whose relative price has fallen. In
Quantity of curds
the case at hand, the substitution effect leads to a
decrease in the consumption of curds and an in-
7. a. Ms. Muffet’s initial budget line and her initial
crease in the consumption of whey.
best affordable point, a, are illustrated in Figure
8.21. (The best affordable point is the same
POSSIBILITIES, PREFERENCES, AND CHOICES 147

FIGURE 8.23 FIGURE 8.25

Short Answer Problem 8 (a) Short Answer Problem 8 (c)
6 3

Price of wine (dollars per bottle)

Wine (bottles per month)
5
Carolyn’s
demand curve
4 2 for wine

I3
3

a I2
2 1

1 I1
Budget
line
0 1 2 3 4 5 6 0 1 2 3 4 5 6
Bread (loaves per month) Wine (bottles per month)

8. a. Figure 8.23 shows Carolyn’s budget line. In this
figure Carolyn’s best attainable point is labeled
a. She consumes 2 bottles of wine per month.
b. The reduction in the price of a bottle of wine
rotates Carolyn’s budget line higher, as illus-
trated in Figure 8.24. Here her best attainable
point is b and she consumes 4 bottles of wine
per month. Note that indifference curve
I 3 continues to remain unaffordable.
Short Answer Problem 9
c. When the price of wine is $2 a bottle, part (a)
indicates that Carolyn buys 2 bottles of wine.
When the price of wine falls to $1 a bottle, part
(b) shows that Carolyn buys 4 bottles. These
two points on her demand curve are illustrated
in Figure 8.25, and her (assumed linear) demand
curve is drawn through these points.
FIGURE 8.26
Income (dollars per week)

FIGURE 8.24
Short Answer Problem 8 (b)
6
Wine (bottles per month)

5 Income-time
budget line
b
4
I3
I3
3 I2

a I2
I1
2

L 168
1 I1
Leisure (hours per week)

0 1 2 3 4 5 6 9. Figure 8.26 indicates the initial hours of leisure as L.

Bread (loaves per month) The amount of labor the individual supplies equals
168 hours (the number of hours in a week) minus L
148
FIGURE 8.27
Short Answer Problem 9
Income (dollars per week)
New budget
line
I3
I2
I1
L important household choices. For instance, without
168
Leisure (hours per week)
hours of leisure. After the rise in the wage rate, the
budget line rotates as shown in Figure 8.27. The
total number of hours per week is fixed at 168, so
the horizontal intercept cannot change. However
the vertical intercept increases because the maxi-
mum income that this individual can earn has in-
creased due to the higher wage rate.
The “new” equilibrium amount of leisure the per-
son enjoys is L in Figure 8.27. Leisure remains con-
stant as does the hours of labor supplied.
Why does leisure remain constant? Recall that the
impact on leisure is the net result of two forces
working in opposing directions: The income effect
encourages an increase in leisure, whereas the sub-
stitution effect motivates a decrease in leisure. In
Figure 8.27, these effects exactly offset each other
because the amount of leisure does not change; it
remains equal to L. Because the time spent at leisure
did not change, neither did this person’s labor sup-
ply. In other words, the higher wage rate did not
change the quantity of hours of labor this individual
supplies.
CHAPTER 8
„ You’re the Teacher
1. “It’s certainly true that one of the main goals of
budget line/indifference curve analysis is deriving
the demand curve. There are a couple of reasons for
doing so. First, it’s ‘nice’ to see that we can derive a
demand curve by just assuming that people con-
sume the best combination of goods and services
they can afford. The idea that people make them-
selves as well off as possible is the hallmark of eco-
nomics. This idea represents the basic world view of
an economist; if you think it’s a reasonable assump-
tion, maybe you ought to major in economics!
“Second, the indifference curve/budget line ap-
proach allows us to think about income and substi-
tution effects. These concepts help clarify some
these ideas, understanding why the quantity of labor
people supply has declined as wages rose would be
difficult. If we didn’t know about the income effect,
we’d probably think that people were either irra-
tional or stupid for decreasing the quantity of their
labor supplied when wage rates rose. So this ap-
proach gives us some new insights into how econo-
mists view the world and the factors that affect the
choices that people make.”
2. “Look, you’re wrong about this. I know that both
indifference curves and demand curves slope down-
ward, but indifference curves and demand curves
really are different. In fact, we use indifference
curves to help derive demand curves. But, to see the
difference, think about a demand curve. It shows us
how the price of a good affects how much we will
buy. For instance, your demand curve for frozen yo-
gurt cones tells us how much frozen yogurt you’ll
buy if a cone is $1.50 or how much you’ll buy if
one is $2.00. Indifference curves are different. They
don’t give us the relationship between a good’s price
and how much you’ll buy. Indifference curves show
us different combinations of two goods that leave
you indifferent. You have indifference curves be-
tween frozen yogurt cones and ice cream cones. This
type of indifference curve shows us all the combina-
tions of yogurt and ice cream cones such that you
don’t care which combination you get. So, you see,
indifference curves and demand curves aren’t the
same, so don’t make this mistake.”
POSSIBILITIES, PREFERENCES, AND CHOICES
Chapter Quiz
11. Tommy’s monthly budget line for street hockey
balls and books is plotted with books on the hori-
zontal axis. His budget line shifts rightward and its
slope does not change. Hence
a. the price of a street hockey ball has fallen.
b. the price of a book has fallen.
c. Tommy’s income has risen.
d. the price of a street hockey ball has fallen and the
price of a book has risen.
12. A household’s consumption choices are limited by
a. prices and preferences.
b. income and preferences.
c. prices and income.
d. prices, income, and preferences.
13. Emma has weekly income of $200. A textbook costs
$50 and a pad of paper $1. When Emma’s budget
line is drawn with textbooks on the horizontal axis,
a. the horizontal intercept is 200 pads of paper.
b. the slope of the budget line is $200.
c. the horizontal intercept is 4 textbooks.
d. the budget line shows that Emma cannot buy 3
textbooks.
14. Preferences
a. do not depend on what the person can afford.
b. are shown graphically as a budget line.
c. change when relative prices change.
d. show feasible consumption combinations.
15. An indifference curve shows all combinations of two
goods that
a. can be purchased with a given income.
b. have the same marginal rate of substitution.
c. are preferred to any other combination of the
goods.
d. among which the consumer is indifferent.
The answers for this Chapter Quiz are on page 367
149
16. Right-hand and left-hand gloves are perfect com-
plements. As a result, the corresponding indifference
curves
a. are L-shaped.
b. intersect each other.
c. are straight lines.
d. are vertical.
17. At the best affordable point,
a. the indifference curve crosses the budget line.
b. the marginal rate of substitution exceeds the
relative price of the goods by as much as possible.
c. the consumer is on the highest attainable indif-
ference curve.
d. None of the above.
18. The income effect from a price change
a. is always greater than the price effect.
b. is always greater than the substitution effect.
c. always leads to an increase in the purchase of the
good whose relative price has fallen.
d. None of the above.
19. When the relative price of a normal good falls, the
substitution effect results in an ____ in the quantity
purchased and the income effect results in an ____
in the quantity purchased.
a. increase; increase
b. increase; decrease
c. decrease; increase
d. decrease; decrease
10. An increase in the wage rate
a. has a substitution effect and an income effect.
b. has a substitution effect but does not have an
income effect.
c. has an income effect but does not have a substi-
tution effect.
d. has neither a substitution effect nor an income
effect.
150